Opinion: How the ‘Trump bump’ to the U.S. economy could fall flat

DavidA. Levy

Investors have scurried to figure out what to expect from both President-elect Donald Trump’s administration and the next Congress, and they have settled, at least for now, on a mix of pro-growth, pro-profits, and pro-inflation measures.

Deregulation will be pro-growth, they judge. Anticipated tax cuts will be pro-profits, as will infrastructure investment. Protectionism will be pro-inflation.

Needless to say, U.S. stocks have soared and Treasury bonds have been hammered since Election Day. Investors are nervously trying to assess their asset allocations. Should they jump on the bandwagon in stocks? Get out of bonds before the “deflation of the bond bubble” goes any further?

Although the bond selloff and the rally in some risk assets may have a way to go, investors giving into these temptations do so at the risk of being blindsided by the very force that, unrecognized by most economists, bears ultimate responsibility for the presidential election results.

This force is the effect of a seemingly innocuous but earth-moving secular change: private sector balance sheets (both debt and the value of assets) becoming larger and larger in proportion to incomes and economic output.

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Here’s why this matters: In any market economy, business cash flow or household income must be adequate to service debt and to provide acceptable rates of return on assets. However, doing either is more difficult in the current big-balance-sheet economy, when each dollar of cash flow must service more debt and validate a greater value of assets. This means that the level of interest rates and the restrictiveness of lending standards become critical factors which can make the difference between recession and expansion.

If the United States lived in a vacuum or in a financially strong global economy, the projected Trump policies probably would lead to stronger economic growth, business profits, and inflation. But the U.S. exists in a world in which most economies are afflicted with greatly overextended private balance sheets — more debt than they can reliably service, as well as assets with dubious ability to generate returns that justify their current market values.

Threats to financial stability abound, whether from a rise in interest rates, a reduction in the willingness of banks or global investors to lend, or disappointing returns on investment. Global financial turmoil could rattle markets before the projected Trump administration fiscal boost takes effect.

These risks are seriously underestimated, if not overlooked entirely, because of widespread ignorance about the wider implications of both total private debt growing faster than total income and the total value of assets growing faster than total income. Consider these three facts of economic life:

1. Total debt cannot rise faster than income forever because debt must be serviced out of income.

2. The total value of assets cannot rise faster than income forever because assets’ values are ultimately based on the income they generate.

3. A private economy depends on balance sheet expansion to generate the profits needed to power the business sector.

Together these facts imply that the expansion of private balance sheets relative to incomes eventually reaches a limit. At that point, profits will be crushed unless supported by government deficit spending or a trade surplus with the rest of the world.

In the U.S. in 2008, the effects of outsized balance sheets on the economy took center stage, as asset price declines and rampant credit defaults brought the global financial system to the brink of collapse. Since then, the U.S., Japan, and Europe have all employed near-zero interest rates and still have not been able to induce much new balance sheet expansion. Their economies have thus depended heavily on government deficit spending (and a large trade surplus in the euro area) to support the flows of profits to business necessary to keep the economy operating.

During the post-2009 business expansion, as developed-market economies were hamstrung by their balance sheet burdens, the greatest source of global profits became massive and rapidly expanding net investment in emerging markets and in global commodities to meet surging emerging-market demand.

Developed-market balance sheets stagnated, but emerging-market (EM) balance sheets expanded rapidly. The EM boom has been to the present global business cycle what the housing bubble was to the previous one. EMs have kept expanding export capacity as if they still had small and rapidly growing shares of a global market in which demand was dominated by relatively stable developed economies.

In truth, EMs have outgrown the global market, and to make matters worse, developed-market demand has been sluggish. Meanwhile, overcapacity, excessive debt, and the resulting financial strains have turned EM private investment down, and in some cases private balance sheets in these countries have been flirting with contraction.

The commodities part of the bubble has already burst, but the slowing of EM fixed investment is gradual and threatening to plunge because of the severe overcapacity. Defaulting private borrowers will strain EM banking systems, and weakening currencies will increase the strains of servicing hard-currency external loans.

One critical factor has kept emerging markets from spiraling into recessions and financial crises: low global bond yields. Rock-bottom U.S., European, and Japanese yields have forced global investors to take more risk in a desperate search for returns, which led them to emerging market assets. A flood of incoming international capital has thus enabled troubled EM businesses to maintain credit lifelines to keep operating. This capital has also made possible large debt sales by EM governments, facilitating deficit spending that has helped keep their economies expanding.

This precarious financial situation explains why EM currency and capital markets nosedive whenever U.S. bond yields spurt higher, such as in the summer of 2013, the first half of 2015, early 2016 — and now.

Rising yields suck investors out of emerging markets, reducing access to capital and driving down their currencies. It doesn’t take long before EM governments are forced to defend their foreign-exchange rates by raising domestic interest rates and cutting deficits, propelling their economies into worse trouble.

An emerging-markets slide would rapidly become a global downturn

Rising U.S. interest rates and the selloff in U.S. Treasury bonds, if not reversed, will trigger the EM sector economic plunge that has threatened the world for several years. An emerging-markets slide would rapidly become a global downturn; emerging markets have huge financial ties to Europe’s already overexpanded and overburdened banking system, so trouble would spread quickly.

The U.S. economy has weathered turmoil in the emerging markets before — but never when the emerging markets represented nearly half of the world economy, as they do today. The bottom line for 2017 is that fiscal stimulus, if and when it comes, may be only a counterweight to cushion a severe global downturn.

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